Introduction
Underpricing of Initial Public Offerings (IPOs) is a historic norm in both developed and developing. Hiring of underwriters to place reasonable price for IPOs has been a custom of equity markets with average under pricing in between the range of 10-17. However, during last decade, world view most unjustified under pricing ratios with the level rising to over 50. From the 7 under pricing in 1980s to 15 ratio of under pricing during early 1990s, the ratio has raised to substantial levels during 2000s (Loughran and Ritter, 2004). The increase in under pricing is mainly attributed to potential gains or returns that investors and even ownersissuers achieve on next few days or after lockup expiration. The key indicator for determining return achieved by investors is the intraday return which measures single day change in price and therefore, gains for investors.
While the general assumption about motives of under pricing are often highlighted in several research works, it has been a controversial issue given the potential manipulation by IPO firms and underwriters. According to Securities and Exchange Commission and National Association of Securities Dealers, the investment banks acting as managers of security listings, have artificially manipulated prices of IPOs to gain from inflated returns. Several unlawful commissions obtained by investment banks have been detected by lawsuit firms which were collected in return for illegal trading activities and artificial demand of IPOs.
While thorough research projects for developed and developing nations is easily available for investors references, particular attention is drawn towards Asian markets that have booming equity markets and attract investors around the world. Several researchers have investigated IPO process, their under pricing and associated factors in Hong Kong, however, there is very limited up to date data available for potential investors.
Very limited number of authentic researchers has investigated the relationship between the rate of subscription and the underpricing of IPOs in Hong Kong from 2003 onwards. During 2000s major structural and economic changes have taken place in the equity markets around the world including the Asian markets. One of the two major structural changes includes mergers between equity and derivative exchanges around the world and between Hong Kong Stock Exchange and Hong Kong Futures Exchange. Also Hong Kong since 1990s has seen several remarkable improvements in the market conditions due to capital inflows from Chinas outstanding growth. The period after 2000s holds importance from a perspective of a boom in economy that has brought changes in analysis of factors affecting the IPO issues and their returns. This project intends to investigate the trend of IPO under pricing in Hong Kongs market and its effect on intraday returns of investors. The intraday return is measured on basis of rate of subscription and market price of IPO on listing day. Where developed countries like France, Germany and UK had under pricing ratios of 16.5, 40.2 and 39.6 during early 2000s, developing Asian countries had under pricing ratios in range of 18 to 50 (Chi, and Padgett, 2005).
Apart from intraday return and subscription rate, there are several cost related factors associated with IPO under pricing that will be considered in analysis of Hong Kong market. The IPO allocation process in Asian markets varies from developed countries as in Asian market non-discretionary allocation is done. In non-discretionary IPO allocation process, funds are taken from investors up front and are held until process of allocation ends. Such process involves certain amount of cost on investors behalf which must be subtracted from overall return for IPO. Apart from this, underwriters compensation and listing costs are also included in IPO process. The intraday returns are analyzed on basis of first day return as well as financing and listing costs.
IPOs and their underpricing is a norm in equity markets since it is a strategy used by firms through underwriters to attract new investors for a potential gain. The pricing of an IPO is determined on basis of several factors which include the book value of the shares being offered, its debt to equity ratios, asset-backing ratios and several other performance and composition based factors. The investors of IPOs are normally keen on earning an intraday return for their investment in IPO. Intraday return is commonly used as a measure of initial public offering (IPO) underpricing (Chi Padgett, 2005). The more underpricing of an IPO will provide more return for the investors but more opportunity loss for the previous shareholders or firm (Ross, Westerfield Jordan, 2008).
An equal important concept is that of subscription rate which refers to the number of applications that are received for subscription of the IPO that is being launched. Loughran and Ritter (2004) reported that underpricing in the US ranged from 7 in the 1980s to 15 in the 1990s before declining to 12 in the post-bubble period. The underpricing practices differ in different states based on their underwriting practices in each country as well as the information available to and demanded by the investors regarding factors that formulate the pricing for IPOs. A study by Chen, Firth and Kim (2004) provided an insight into the Chinese stock market and their techniques of IPO underpricing. Similarly, Kucukkocaoglu (2008) presented a paper on comparison between international practices of IPO underpricing and the one being followed in Turkey. Hong Kong stock exchange (HKEx) is relatively a volatile market given the developing stage of its economy and financial industry and therefore, has attracted several researchers towards studying the performance of its IPO market and considering the underpricing techniques used. Information about the ratio of the adjusted net tangible assets per share to the offering price (the assets-backing ratio) and the rate of subscription is publicly available to investors. However, the importance of these factors in determining the underpricing of IPOs and its outcomes is unclear for many economies where the research is either incomplete or prior the major economic changes in that state. For instance, the studies on IPO underpricing in Hong Kong and the major factors associated with it are dated back to late 1990s and therefore, provide less discerning and valid information for investors who are looking for investment opportunities today.
Lack of information regarding Hong Kongs market during 2000s is a hindrance to knowledge of international investors who are in search of factors related to IPOs that affects their initial returns and therefore, returns for investors money. For instance, the severe under pricing of IPOs witnessed during 2000s with its first day return reaching to level of 65 is unexplainable to common investors and even to some analysts. The motive of this paper is firstly to understand the reasons for under pricing of IPOs in Hong Kong and study of various factors that directly or in directly affect IPO underpricing as well as intraday returns. These factors include rate of subscription of an IPO which again is related to asset value of firm that is ready to be listed on stock exchange as well as information asymmetry that is present in markets. Apart from this, factors like subscription rate and asset-backing ratio are then tested against underpricing levels and intraday return to determine the extent of direct or indirect relationship between these factors.
The main objective of this study is to determine the relationship between various factors that lead to under pricing tactics by organizations and the relationship between rate of subscription and asset-backing ratio to IPO underpricing based on their initial returns. The relationships will also be determined interchangeably for instance, relationship between rate of subscription and intraday return will also be determined.
The study contains several sections contributing to the analysis of the paper. The statement of research will provide a detailed description of what the paper investigates in this research and what are the main questions to be answered. The purpose of conducting a research of this sort is also explained along with its significance to various groups of readers including investors and analysts. The sample for this study consists of databases related to around 284 IPOs that have been listed on HKEx during the period of 2003 to 2008. Since there are no recent studies conducted on similar area in Hong Kong market, the data used in this study provides fresh information and analysis.
The project is divided into several sections that provide overview of Hong Kongs IPO market as well as selection of IPOs to be analyzed. Secondly, the major explanations offered for the underpricing of IPOs by major researchers and scholars are provided. This also gives a way to further analysis of factors and hypotheses that are needed to be developed in this research. The next section will proceed to discussion of measurement of variables and determination of relationships between various elements related to IPOs and methods that will contribute towards establishment of that relationship. Finally, the measurement methods will be applied to test hypotheses presented above and results will be presented along with discussions. Further explanation of chapters is given below.
The literature review provides a summary of past and current trends in empirical research on IPO underpricing. The section will review contributions of several researchers in the field of studying Initial Public offerings and its underpricing in various countries and specifically Hong Kong. Then the methodology will include different sections providing information pertaining to the research methods that have been employed in this paper. Several models and hypotheses have been developed to explain this phenomenon. Finally the data collection and analysis will summarize the whole research into tangible and valid conclusions based on results gathered from using the research methods chosen earlier.
Statement of the Research Problem
Several researchers after 1980s have shown immense interest in the initial public offerings, its price calculation, initial returns and the impact of various factors like subscription rate, asset-backing ratios and company performance on underpricing of these IPOs. Loughran, Ritter, and Rydqvist (1994) completed a comprehensive survey of companies going public in 25 countries from 1980 to 1089. They found that the average initial return in Hong Kong was 17.6. Chong, Yuan, and Yan (2006) mentioned that the average IPO underpricing level for H sharesshares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange (HKEx)from 1993 to 2003 was about 16.8. This figure is similar to the level of underpricing found in developed countries. Prior studies have presented various models to explain the underpricing of IPOs.
Kiymaz (1998) presented a paper on review of performance of Turkish IPOs through assessment of underwriting techniques and methods used by underwriters in Turkey. The study analyzed IPOs launched during 1990 and 1996 on Istanbul Stock Exchange (ISE). Similarly various researchers (Chen, Firth Kim, 2004 Kucukkocaoglu, 2008) have conducted empirical research on establishing relationship between valuation methods and under pricing of IPOs in different countries including Turkey, China and Bangladesh, using listed IPOs for a specific time period. Kucukkocaoglu (2008) in his study analyzed the IPO underpricing methods in Asia and recommended methods to control the volatility in these markets. Umutlu (2008) also focused on factors like pecking order and timing that can affect performance of IPOs.
Prior studies have presented various models to explain the underpricing of IPOs. Burgstaher and Divhev (1997), during their research on IPOs inferred that asset value of firms present a curve function which means that they are relative to values of firms earnings as well as its book value. Among these factors book value factor is the most important factor affecting value of firm. Based on the book value of firm, underwriters deduce firms IPO initial price offer. Therefore, it can be concluded that underpricing of IPOs is somehow related to net asset value of firms.
Similarly, rate of subscription is another important factor that is based on demand for IPO of a firm. The more demand is created for a specific firms IPO the greater will be its subscription rate. Studies by Vong, conducted in 2006 as well as in 2009, consider IPOs in Hong Kong that went public during late 1980s and early 1990s. However, no research has been conducted on the relationship between the assets-backing ratio and the underpricing of IPOs in Hong Kong from 2003 to 2008. No research based on this time frame tests the relationship between the assets-backing ratio and the underpricing of IPOs in Hong Kong. This study attempts to fill that gap.
This study also seeks to address the idea that the subscription rates of offerings provide valuable information about how the intraday returns affect the first day of trading for a companys stock shares on the HKEx. Given the importance of these factors, it can be said that this study has two main objectives. Firstly, this study intends to record extend the IPO data for Hong Kongs stock market and present the level of underpricing that took place during more recent period i.e. during 2000s. Given this objective the period of 2003-2008 is chosen to incorporate latest changes that have taken place on worlds economic platform. This period enables a relatively large sample of issues to be examined by considering a substantial number of Hong Kong IPOs following economic inflation and then bubble burst in 2003 and economic deterioration in 2008.
After examination of level of underpricing in Hong Kong, the project will evaluate the main area of research which includes understanding of factors that positively and negatively affect intraday returns of IPOs. These include the level of subscriptions and asset-backing ratio which incorporates a firms asset value. This area of study draws largely upon the existing models for levels of underpricing (Baron, 1982 and Rock, 1986) and the related theoretical and empirical literature derived from these models. From this literature, a number of hypotheses are formulated and tested.
Despite various studies conducted on IPOs in Hong Kong and the factors affecting them, there is a need for information upgrading for the investors and analysts. During 2000s major structural and economic changes have taken place in the equity markets around the world including the Asian and European markets. Hong Kong has been given tremendous attention by investors around the world for its continuous progress and investment products. The performance of IPOs and their underwritings methods, therefore, have also seen changes that have affected their performance. This study attempts to fill the gap between the previous studies that have attempted to analyze Hong Kong markets performance during early 2000s and the current performance of Hong Kong markets, before and after the market downfall worldwide. This study extends the body of research presented by Vong (2006), who used 251 samples to conclude that there was a relationship between the rate of subscription and IPO underpricing in Hong Kong from 1988 to 1995.
Purpose of the study
The purpose of this study is the understand level of underpricing in Hong Kong and study related factors that can further analyzed by investors or potential investors in determining potential returns of newly listed IPOs. This research applies a quantitative statistical study to determine the performance of IPOs in Hong Kong based on its initial returns. The study also uses qualitative approach towards understanding the methods of underpricing in Hong Kong and the reason for using underpricing tactics in IPO listings. The study will investigate the relationship between various factors related to IPOs including rate of subscription and its relationship with asset backing ratio as well as the intraday return after initial launch.
This research applies a quantitative correlational study to determine whether the assets-backing ratio can be used as an explanation for the IPO underpricing phenomenon, and also is to investigate whether there is a correlation between rates of subscription and the IPO underpricing phenomenon.
The data used in the research in this paper has been retrieved from several sources. The sample for this study consists of databases related to 284 IPOs that have been listed on HKEx during the period of 2003 to 2008. Since there are no recent studies conducted on similar area in Hong Kong market, the data used in this study provides fresh information and analysis.
Research Questions
The research paper examines the methods of underpricing in Hong Kong stock market and the performance of IPOs based on their initial returns and relative to the Hong Kong Stock Exchange. This paper also evaluates the relationship between the assets-backing ratio, the rate of subscription, and the intraday return of IPOs in Hong Kong. Li (2008) indicated that, as net tangible assets per share increase, a companys fundamentals typically improve. Vong (2006) showed that the subscription rate is of paramount importance in understanding the underpricing and aftermarket volatility of returns of new offerings in Hong Kong.
Following are the research questions to be investigated in this study
What is the degree of relationship between the assets-backing ratio and intraday return of the IPO
What is the degree of relationship between the rate of subscription and the intraday return of the IPO
The research questions investigated in this study have already been a matter of interest for various theorists and researchers. Vong (2006) and McGuinness (1992) in their studies have revealed the importance of asset-backing ratio and rate of subscription in determining the intraday return of IPO and its overall valuation. Both researchers have found positive and significant relationship between IPOs under pricing and asset-backing ratio and rate of subscription. The similar research questions in thus study are chosen to include the currently prevalent market conditions in Hong Kong and demonstrate the level of importance of these factors in affecting the returns of an IPO. The relationship between asset-backing ratio and intraday return of IPO will help the investors analyze a firm, preparing for listing, from its balance sheet and financial performances perspective.
Similarly, the rate of subscription determines how much return an investor can make during IPOs initial launch and therefore, help them analyze the future potential of an IPO beforehand.
Significance of Research
Information about the assets-backing ratio and the rate of subscription is publicly available to IPO applicants. All IPO applicants need to submit funds to the underwriters. During the IPO investment period, IPO issuers are able to earn interest on all the subscription funds, regardless of whether the IPO subscriptions are successful. IPO applicants incur finance charges or opportunity costs when their funds are locked during the IPO investment period. To compensate for these locked-up funds, it is worth estimating IPO underpricing for seeking a reasonable return.
Previous studies on rate of subscription and market volatility in Hong Kong were done based on statistical tools like regression analysis and theoretical research. Studies by Vong (2006) and McGuinness (1992) lack validity under current market dynamics and investment atmosphere. Also the time frame for previous studies goes way beyond the period of current investors interest and therefore, an empirical research based on present market conditions of IPOs in Hong Kong is required for the investors.
From the viewpoint of IPO applicants, the net tangible assets per share are an indicator of applicants investments margins of safety if the assets can convert to cash. In view of margins of safety, it is worth testing the correlation between the assets-backing ratio and the intraday return.
Under the listing rules of the HKEx, the rate of subscription is publicly available information that is accessible to IPO applicants before they trade a share. Vong (2006) showed that the subscription rate is crucial for an understanding of the underpricing and aftermarket volatility of returns of new offerings in Hong Kong from 1988 to 1995. When investors participate in a secondary market of over-subscribed new shares, the Investors actions inadvertently influence the intraday return. The correlation between the subscription rate and the intraday return would also be worth testing.
If there is a relationship between the assets-backing ratio and the intraday return of IPOs in Hong Kong, IPO applicants can forecast the intraday return when a prospectus is issued. The rate of subscription is an unpredicted factor related to the intraday return, as the rate of subscription will become known after investors have already subscribed. However, no research has been conducted on the relationship between the rate of subscription and the underpricing of IPOs in Hong Kong from 2003 to 2008.
Definition of Key Terms
IPO is an abbreviation of Initial Public Offering which refers to the first sale of stock by a company to the public (Draho, 2004).
Assets-backing ratio is defined as the net tangible assets per share divided by the offering price of the initial public offering (Burgstaher Divhev, 1997).
Intraday return of initial public offering is the return between the offer price and the closing price on the first trading day and is therefore the initial public offerings preliminary return (Cheng, Cheung, Po, 2004).
Rate of subscription refers to the ratio of the number of shares applied divided by the numbers of shares allotted (Vong, 2008).
Net tangible assets per share is defined as the net tangible assets as shown in the audited accounts plus the estimated net proceeds from the initial public offering, divided by shares issued and shares to be issued upon the initial public offering.
Underpricing of initial public offering refers to the extent of the intraday return of the initial public offering (Chi Padgett, 2005).The higher the intraday return, the higher underpricing a new offering is assumed to have.
Information Asymmetry refers to conditions in which some relevant information is known to some but not all parties involved.
Winners curse refers to a tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased due to incomplete information regarding the product being auctioned (Meyer, 2003).
Over subscription is the excess demand for bonds or shares by investors and buyers where shares or bonds are not available due to high demand (Booth, 1996).
Litigation Avoidance Hypothesis is a concept that was initiated by American corporate sector where the initial sales of shares are made on low prices to avoid any future lawsuits by investors regarding the under expected performance of shares (Eckbo, 2007).
Underwriter refers to a company or individual who administers the public issuance of securities from corporations (Faerber, 2006).
Literature Review
Going public marks an important cut-off point in the life of a young company. It is a major decision that affects capital structure of a company along with its funding expenses. Going public involves access to public equity capital and therefore, the firm can lower its funding costs, operational costs and increase investments (Eckbo, 2007 Draho, 2004). The shareholders for the company also benefit from the activity level of markets that provide them capital gains as well as diversify their investments. It also provides a venue for trading the companys shares, enabling its existing shareholders to diversify their investments and to crystallize their capital gains from backing the company which is an important consideration for venture capitalists (Ritter and Welch, 2002). Companies that go public gain an additional benefit of publicity among players of financial markets as well as skilled labor and management.
Where going public provides several benefits, it also causes costs of maintaining public information regarding firms activity, transparent accounts and other disclosures (Kooli and Suret, 2001 Zutter, Chad and Scott, 2005). In addition to this, firms become liable to several shareholders in form of providing revenues as well as dividends. The owners of firm forego the benefits that might be earned through a venture capital since in a venture capital the investors contribute towards decision making of management regarding various projects. However, in equity funding, investors tend to push in and pull out money whenever they deem appropriate or when projects undertaken take time to pay off (Kooli and Suret, 2001).
Going public requires firms to register for IPO listing which refers to Initial Public Offering. IPOs are normally priced by underwriters according to listing firms asset position and future potential as well as demand created in market due to information available. IPOs have been a keen interest of several researchers around the world for decades. According to Logue (1973) and Ibbotson (cited in Vong, 2006), when companies go public, they tend to manipulate information a bit in order to sell IPOs at underpriced levels so that they can earn positive profits on early days of trading.
Initial Public Offering (IPO) is the first public equity issue that a company makes when it is preparing for a public listing (Ross, Westerfield Jordan, 2008). Yong (2007) suggested that the literature regards IPOs as offering positive initial returns (usually measured as a percentage change from the offer price to the closing price on the first day of trading) both in the US and within the international market. Various researchers have investigated the reasons for underpricing, its implications and relationships with several factors like rate of return, role of subscription, financial ratios and valuation of companies. Pons-Sanz (2005) presented a paper on why IPOs are underpriced and the stakeholders that benefit from this underpricing. Similarly, several researchers (Cao Shi, 1999 Clementi, 2000 and Chi Padgett, 2002) have investigated the characteristics of IPO underpricing and its implications on various groups and countries. Normally, besides the purpose of fund raising and investment, an IPO often takes place with a motive on behalf of owners to earn as much gain as possible from first day trading of IPO. This fact is supported by several researchers (Franks, 2008 Vong, 2006) who have analyzed several benefits that can be attributed to under pricing of IPOs.
The under pricing technique can only be used by people and management insider the firm who have access to legitimate information regarding company present and future motives as well as asset value. Several researchers in their paper discussed the factors of insider knowledge which includes factors of ownership control that gives management an edge over other investors regarding manipulation of price of IPO through subscription rate or information dissemination (Zutter, Chad, and Scott, 2005 Ljungqvist, 2006 Gajewski, and Gresse, 2008).
Underpricing of an IPO refers to initial trading of securities at a price which exceeds the offer price at which the IPO is being sold to investors (Gajewski and Gresse, 2008). Investment in an IPO is a reasonable risk for investors who are less aware of actual market price of the firm and have to depend on the initial valuations presented by issuers. When the offer price is higher than the expected and assumed price level of investors, potential investors will show less interest in the IPO issue and will look for alternatives (Li, 2005 Yong, 2007). However, if the price is lower than their expected price, the potential investors will subscribe for IPO, however, the benefits for issuing firm will reduce a bit initially.
In order to balance the gains for both issuers and investors, the underwriters will place IPO issues at level that will create a win-win situation for both issuers and investors. The concept of under pricing is authenticated by several researchers around the globe (Rock, 1986 Baron, 1982 Vong, 2006 Campbell, Du, Tang and Rhee, 2008 Kooli and Suret, 2001). Various theorists have conducted research on analysis of IPOs, evidence of their existence and reasons for this phenomenon of under pricing.
Evidence of the Underpricing of IPOs
In the literature, the intraday return is commonly used to measure the degree of IPO underpricing (Chi Padgett, 2005). Early researchers including Logue (1973) and Ibbotson (1975) investigated the IPO markets and their functioning. They found that when companies go public, they tend to sell shares that are underpriced therefore, the share price jumps substantially on the first day of trading. Since the 1960s, the initial price of IPOs has been discounted on average around 19 in the US. Loughran, Ritter, and Rydqvist (1994) provided a comprehensive survey of companies that went public in 25 countries and analyzed their performance. The researchers used statistical approach with data regarding the average initial returns for companies in 45 countries. They found that the average initial return in Hong Kong was 17.6. Chong, Yuan and Yan (2006) analyzed the IPO underpricing for H shares through empirical evidences from the IPOs listed on Hong Kong Stock Exchange during the period of 1993-2003. Chong, Yuan, and Yan (2006) mentioned that from 1993 to 2003, the average IPO price for H sharesshares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchangewas discounted about 16.8. This figure is similar to the level of underpricing that is observed in developed countries.
Vong explained the relationship between rate of subscription and IPO underpricing in Hong Kong market and used regression model to proof the hypothesis. Vong (2006) found that the IPO price was discounted by 15.02 on average for 251 companies that went public in Hong Kong from 1988 to 1995. Kucukkocaoglu (2008) conducted a study on Istanbul Stock Exchange and revealed that out of the three IPO methods used in Turkey, underpricing through fixed price method provides the most efficient method for controlling the volatility of stock market. He also observed that in fixed price offer the underpricing was of 7.01 while in book building method and sale through stock exchange is 11.47 and 15.68 respectively. Umutlu (2008) studied the impact of market timing and market to book ratio on IPO aftermarket firms and their performances. Similarly, Kiymaz (1998) in his research showed that till 1999, the IPOs in Turkey were discounted on initial trading day by almost 13.1. Kurtaran and Bunyamin (2008) determined relationship between managerial ownership and post issue operating performance of IPOs as well as relationship between post issue operating performance and underpricing level. They found that underpricing affects only the initial returns of IPO and that in the long run managerial ownership impacts the long run performance of the issue.
Another way to measure IPO under pricing is through measuring money left on the table. Money left on the table is a significant terms used to indicate the difference between aftermarket trading price and the offer price multiplied by the number of shares sold at the IPO (Ritter, 2003). The concept of money left on the table implies that the demand in secondary markets in inelastic and therefore, offer price of an IPO is capable of being equal to the market price at which it is initially traded.
The concept of money left on the table is interesting for investors as it instigates the researcher to question the way IPOs are under priced. As shown in Figure 1, 2, and 3, markets around the world are actively involved in under pricing of IPOs with the most active country being the United States based on number of IPOs launched and capital raised through these issues (Ritter, 2003). As shown in figures, the under pricing level raised between 10 to 20 during 1960s and 1980s, however, after 1980s a boom can be observed in the levels of under pricing worldwide, which indicates higher degree variation (Ritter, 2003). As shown in figure 1, there are very few instances of IPOs being overpriced since most of the time they are listed at huge discounts to their market value. The figures also depict periods in early 1990s and 2000s when the trend of hot issues entered the market and pulled the under pricing levels above 70, generating huge initial returns while leaving substantial amount on the table. The trend of hot issue markets is a gift of technological era where high tech firms created large bubbles in equity markets resulting in high IPO clusters and less long term gains. A recent launch of Google firms IPO (cited in Chambers, and Dimson, 2009) is an excellent example of high level of under pricing in markets and specifically in high tech firms. The level of under pricing varies from country to country with countries like France and Germany being on the lower side of under pricing levels and Asian markets on the high levels (figure 2 and 3). Such differences in level of under pricing can be attributed to different market structures, regulations and institutional frameworks that restrain some countries from breaching a certain level of under pricing or intraday returns. While in developing economies these market frameworks are often expected to be more lenient that leads to higher levels of under pricing and no upper restrictions on intraday profits that can be earned on IPOs (Sahi and Lee, 1999 Bundoo, 2007).
Explanations for IPO Underpricing
IPO under pricing is a well researched and well documented concept that gained attention during 1970s after evidences of high profits that could be earned for issuers and investors (Booth and Booth, 2003). Baron (1982) in his study explains the concept of information asymmetry that can be termed as a major reason for rising under pricing levels. This result is supported by several theorists who claim difference of valuations in investors eye and issuers perspective as a major reason for IPO under pricing (Pritsker, 2006 Favero, Pagano and Thadden, 2005 Ritter and Welch, 2002 Titman, Trueman, 1986). Similar searches also prove that the issuers or firms that are planning to go public prefer under pricing their issues. The reason is attributed towards benefits of high initial returns that issuers, being the well informed group, get. The asymmetric information that is available in market creates groups of investors and issuers that have different valuations and demand for companies IPOs (Rock, 1986 Fernando, Krishnamurthy and Spindt, 1999).
Sherman (2004) also suggests that under pricing phenomenon is adopted willingly by issuers as it provides several benefits to them. One of the benefits for this under pricing, besides the benefit of higher returns, is protection against any legal action by investors. The higher issuers set the price level, the greater are chances of investors and regulatory bodys interference and probing into the IPO issue. In order to avoid such probing and any potential lawsuits, issuers prefer to place IPOs below its par value. This phenomenon is also known as Litigation Avoidance which is a popular practice in developing countries like United States (Carter Manaster, 1990 Gregoriou, 2006 Gajewski and Gresse, 2008). Ritter and Welch (2002) in their study presented another benefit for under pricing which posits that well known under writers and issuers prefer under pricing of issues in order to create a favorable market of investors for future offerings. A loyal set of investors is an important back up for issuers and under writers who can gain from them in future when market for IPO is on downward lane or is less profitable.
The level of under pricing in various markets requires creation of hypotheses that can explain the IPO markets and give objective reasons for these methods. Most of the studies regarding under pricing of IPOs are based on earlier studies developed by Rock (1986) and Baron (1982) who presented technical models for explanation of IPO under pricing. These models included several factors like rate of subscription, book value of firm to be listed, intraday returns, timing of IPO launch, and other factors that are highly correlated to pricing of IPOs. For instance, Baron (1982) explained the rationale of information asymmetry that exists between underwriters and issuing firms. According to him the investment bank that is dealing with the issue has more access to information regarding market demand and potential investors and therefore, can do right pricing for a specific issue. The firm on the other hand is unaware of underwriting techniques and existence of demand in market and therefore, cannot value the IPO issue as accurately as the underwriter (Favero, Pagano, and Thadden, 2005 Chung, Li and Yu 2005).
Rock (1986) on the other hand studied similar groups of investors and issuers. However, in Rocks model the availability of information is opposite as he took group of informed investors and less informed issuing firm. In case presented by Rock, level of under pricing increases due to information asymmetry that exists between different groups. Rock (1986) developed a model in which the investors are initially unaware of market value of the issue. However, as information is available in the market by research groups and industry comparison, the investors pay additional costs to obtain accurate information regarding issues price. Now the investors will seek the offer price below their valuation or target price. When the offer price is more than valuation, informed investors are not interested in the issue and therefore, only a small lot of uninformed investors purchase the issue (Ross, Westerfield, and Jordan, 2008). However, if the underwriter offers IPO price at discount, a larger lot of informed and uninformed investors purchase the issue. This will result in oversubscription of the issue which will further lead to rationing process by underwriters. This process of rationing will again lead to under pricing as there will be more incentives for issuers to sell IPO at discount (Loughran, Ritter Rydqvist, 1994 2002).
The phenomenon presented by Rock (1986) was later popular under the concept of winners curse where uninformed investors get more chances of obtaining IPO issue when subscription rate is low. On the other hand when issue is underpriced or oversubscribed, more informed investors are expected to participate (Loughran Ritter, 2002). Given the model of Rock it can be concluded that presence of more uninformed investors leads to uncertainty about market price of the issue and when market price of issue is uncertain, investors will be less interested in the issue. In order to attract such lot of investors, the underwriters need to under price the issue. Therefore, it can be proved that information asymmetry leads to biases about issue and thus, increases the level of under pricing (Rock, 1986 Baron, 1982 Kiymaz, 2000 Ljungqvist, 2006).
The earlier models mentioned above suggest that information unavailability or biases exists till the launch of IPO in secondary market. As soon as the trading of IPO starts, the price of IPO adjusts further for its potential value and the pre IPO participants gain the maximum out of their investment. As mentioned by Rock (1986) and Mahmud, M. A., and Rahman, A. H., (2006) and Williams, Duncan and Ginetr (2006), initial participants of IPO market should be the one with maximum benefit in market trading as they should be able to obtain benefits out of under pricing. This is because after the IPO trading starts, the price of IPOs adjust themselves for their actual value.
According to Welch (1992) after the trading of IPOs starts in secondary markets, new information flows from new individuals and in order to gain extra ordinary initial or intraday returns, pre-IPO investors ignore the previous information while following the market trend. Strong IPOs with greater initial returns have even greater intraday returns with formation of speculative bubbles that affect the returns positively.
Various explanations have been offered for the underpricing of IPOs. These models and hypotheses have changed over time. Four models or hypotheses have emerged to provide more reasonable and empirically-testable explanations for IPO underpricing. The following section provides a review of these four hypotheses. However, many other explanations that are unique to developing countries like Turkey are still need to be explored (Yong, 2007).
Asymmetric-Information Models
The asymmetric information phenomenon is discussed by Baron in his paper regarding the underwriters using theoretical analysis. Baron (1982) proposed that information asymmetry between underwriters and issuers cause a significant first day return. Essentially, this means that the underwriters possess superior information regarding the demand for the IPOs, but the issuers are not able to see the underwriters distribution efforts. As a result, the underwriters minimize their efforts toward selling the IPOs by offering them at a discount. When investment banks are hired by issuing firm for launch of IPO and setting its pricing level, potential investors feedback is used to gather information regarding demand of firm. When there is lack of information available in the market regarding issuing company, the uncertainty level increases thereby, resulting in high risk. The general practice by underwriters is to issue IPO at lower price level or at discounted price so that potential investors are attracted to purchase the IPO. The underpricing often results in reasonable gains for investors and non-interested parties can be given incentive of future offerings to promote IPO issue. The investment banks can utilize both concepts of price as well as allocation to achieve gains in the end otherwise the under price selling of IPO issue will result in limited gains (Kurtaran and Bunyamin, 2008). This asymmetric information anomaly is against the market fair rules since the uninformed investors will lag behind informed institutional investors in gaining equal profits or returns.
The information asymmetry restrains the uninformed investor from participating in issue with good potential while the informed investors take advantage of information participate to a greater extent. With fixed-price offers, potential investors face an adverse selection, also known as the winners curse problem, as suggested by Rock (1986). According to Rock (1986), IPOs should be underpriced using the firm-commitment contract to a greater degree than by using the best-offer contract to compensate for uninformed investors.
There is limited literature available to study the rationing process in different markets and specifically the allocation of shares with real time data. This is due to the reluctance of underwriters to provide data in order to avoid any litigation or probing. A study conducted by Hanley and Wilhelm (cited in Gajewski and Gresse, 2008) gather distribution data for a sample of 38 IPOs managed by a single underwriter during the period 1983-1988. The research showed allocation of 70 of shares to institutional investors while only 30 is allocated to retail investors. Even in issues that have low demand by retail investors, institutional investors have invested greater amounts of capital in those IPOs. These results are in contrast to the theory of information asymmetry presented by Rock (1986) as according to him, the informed investors impose a winners curse over less informed investors.
Another study on information asymmetry in IPO markets by Aggarwal et al (2002) supports the notion of Rock (1986) that institutional investors dominate the IPO market in U.S. (Pons-Sanz, 2006). Aggarwal et al. used a sample of 164 companies that launched IPOs during 1998. According to results of research, the larger profits in IPO market are earned by institutional investors due to information asymmetry and favorable allocation to institutions by under writers. This favorable attitude towards institutions is done by underwriters in order to sell IPOs at higher prices and therefore, compensate their returns for discounted IPOs.
Ljunqvist and Wilhelm (2002) conducted a research in 37 countries with analysis of around 1000 IPOs for year 2000. They found that preference is given to institutional investors by under writers as the retail investors are issued IPOs at discounted price while the institutional investors can purchase IPOs at greater prices to maintain relationship with the issuers. Cheng, Cheung, and Po (2004) while studying the IPO market in Hong Kong found that underpricing occurred for the opening trade of new issues in Hong Kong from September of 1995 to December of 1998. When an oversubscription of IPOs occurred, Hong Kongs share-allotment method favored large investors. Therefore, only investors who apply for large numbers of shares of new issues are likely to reap profits from underpricing (Cheng et al., 2004).
Hill and Wilson (2006) conducted a research on UK IPO market utilizing a unique dataset of 502 UK IPOs. They found that IPOs were underpriced in the United Kingdom. For this study, they conducted an empirical analysis of the relationship between underpricing and value gains on the flotation of shares. Additionally, most empirical studies of IPO underpricing in the literature loosely fall into the following four groups company characteristics, offering characteristics, prospectus disclosure, and aftermarket variables.
The Litigation Avoidance Hypothesis
The litigiousness of American investors has inspired this hypothesis, which explains that IPO underpricing is based on a form of legal insurance or lawsuit avoidance. IPO underpricing can reduce the frequency and severity of future class action lawsuits since only investors who lose money are entitled to damages (Yong, 2007). The basic idea can be traced back to the work of Logue (1973) and Ibbotson (1975). Essentially, companies deliberately sell their stock at a discounted rate to reduce the likelihood of future lawsuits from shareholders who are disappointed with the post-IPO performance of their shares. As Ritter (2003) pointed out, the fear of lawsuits has been mentioned as one rationale for why Internet IPOs were underpriced from 1990 to 2000.
The Signaling Hypothesis
Another frequent explanation for IPO underpricing is the signaling hypothesis, which suggests that IPO firms select prestigious experts such as underwriters to reduce the level of IPO underpricing. In other words, a firms choice to employ higher-quality service providers indicates that they are also a high-quality firm this is communicated by a decrease in the discount offered for the IPO. Titman and Trueman (1986) found that hiring a high-quality expert for an IPO is negatively related to IPO underpricing and that the compensation for and quality of the auditors is also negatively related to IPO underpricing. Carter and Manaster (1990) also reported that low-risk firms try to indicate their quality to the market by selecting prestigious underwriters. However, based on data from 668 Chinese IPOs, in which over 90 represented partially-privatized IPOs, Chi and Padgett (2005) showed that during privatization the government does not emphasize send signals on the quality of the issues through underpricing.
Behavioral Explanations
In the late 1990s, initial returns increased substantially. Behavioral explanations can better elucidate the reasons for underpricing (Yong, 2007). Welch (1992) showed that informational cascades, also known as bandwagon effects, can develop for some forms of IPOs if investors make their investment decisions sequentially. For example, later investors can condition their bids based on the bids of earlier investors, thereby disregarding their own information through rationalization. The phenomenon can be briefly explained as that the initial sales are conceived as a success mark for the potential investors and thereby, increase the future investment in the IPO based on experience of previous investors and is less dependent on their own firsthand knowledge. On the other hand less initial sales or subscription rate is considered an indicative of bad investment and thus, pushes investors back from investment in a particular issue thereby, reducing the demand.
The prospect theory developed by Kahneman and Tversky (1979) asserts that people focus more on changes in their wealth as compared to the level of their wealth. Loughran and Ritter (2002) applied this concept to IPOs by noting that most of the money left on the table belongs to a minority of firms when the offer price is revised upwards during the book-building process. For these issuing firms, executives experience an increase in personal wealth relative to what they had expected based on the file price range even as they agree to leave money on the table. Loughran and Ritter (2002) argued that the issuing firms executives bargain less diligently for a higher offer price in this circumstance than they would otherwise.
Control Hypothesis
Franks (cited in Acedo, Ruiz and Santamaria, 2008) conducted a research on underpricing and several benefits that are associated with it for internal management and underwriters. The research focused on benefit of internal control that owners have on pricing of IPOs. The insiders ensure that IPOs are priced at lower levels so that they are oversubscribed and rationing can be used in share allocation process. This process of rationing is important as well to ensure that clusters of IPO holders are not formed. This discrimination is important to management in order to avoid any clustering of shareholding and thus, hostile takeover can be avoided. This process of share allocation is often referred to as control theory. According to the control theory, IPO underpricing is important to achieve over subscription which later leads to rationing process. The rationing process is in turn another important aspect of IPO allocation which is done by issuers to select investors of their choice and thus, earn high return without involvement of large shareholders (Parlour, 2003 Pritsker, 2006). Also this sort of diffuse shareholding is a more costly process since the larger extent of under pricing will already lead to greater benefits in secondary market and it will be difficult for large investors to assemble large chunks of shares. Even if the shareholders get hold of large chunks, the price of IPO would have already been adjusted according to high expectations of market and therefore, return on each share will be comparatively low (Pritsker, 2006). Another aspect related to this process is the benefits enjoyed by owners or higher officials in issuing firm that set the IPO price and try to bear as low as possible costs for issuance of shares. This low cost for the directors in turn results in greater underpricing.
The process of rationing mentioned above is testified by several researchers and also by the new issuing process in UK where the issuers specify prices for IPO shares and potential investors can quote a quantity or lot of shares they wish to purchase (Lee, Taylor and Walter, 1999 Kiymaz, 2000). Based on the subscription rate either the issue is under subscribed which does not require any rationing process, or it is oversubscribed. In case of oversubscription, the rationing process is adopted by issuers, thereby, achieving maximum gains.
Franks (cited in Campbell et al., 2008) conducted a research on UK IPO market with sample of over 69 IPOs. The procedure used for IPO pricing was fixed price offerings. The research observed change in ownership of IPO shares after launch of shares in secondary market. For instance, the shareholding of directors reduced from 42 to 29 only over a period of seven years while the holdings of private shareholders decline to almost 3 from 42 in beginning. Lastly, the institutional investors including asset management companies and treasuries drastically reduced their investments during the same period. The results from Franks study implied that holdings by directors and other insiders remain as sole stable investment while other investors, especially private and institutional investors, see IPOs as vehicle to generate returns over a small period of time. Therefore, strong holdings of IPO shares by private investors can only be seen as temporary investment in firms.
There is substantial difference among private and public companies regarding ownership of shares and their control. IPOs are used as a vehicle by management and insiders of a company to keep their holdings in private firms that are on their way to become public. Since it is mentioned from above study of Frank (cited in Campbell et al., 2008) that it takes less than seven years for change in ownership of shares as both directors and non-directors dispose-off shares to gain profit, it again points towards the intentional rationing process that is adopted by underwriters and issuers. The reason for this rationing is again to achieve maximum underpricing through oversubscription which is gained through involvement of small investors. It, therefore, implies a strong relationship between IPO under pricing and oversubscription as well as between oversubscription and increased rationing (Sherman and Jagannathan, 2006 Parlour, and Rajan, 2003).Other aspects of the control hypothesis include several propositions with first one being a positive relationship between under pricing and rationing in share allocation process. A large ratio of under pricing leads to assumption that there will be more rationing and thus, more diffusion of shareholding and the smaller clusters will be formed. It can be said that underpricing tends to prevent the formation of large blocks of shares in the hands of outside shareholders.Another aspect of control theory suggests that since costs of under pricing are borne by the insiders, larger costs will lead to greater under pricing. Apart from control theory, there are other concepts presented by researchers that base IPO under pricing on various issues. Miller (cited in Booth Booth, 2003) related demand for IPO on differences in opinion which leads to concept of availability of information in market regarding the firm. Miller (cited in Vong, 2006) also introduced the concept of supply of funding according to which when supply of funding is available in market, the price for an IPO rises to optimal level, i.e. to level where it is maximum compensated for its potential.
However, this concept is often rejected by theorists who assert that there will always be information asymmetry in market which will restrain an IPO price from reaching its optimal level. Also another notion lays in the fact that supply of funding does not guarantee equal amount of investment or subscription level since the interest level of investors vary due to various reasons. Normally, the interest of investors is achieved through setting IPO price below the par in order to attract reluctant investors. The concept of valuation is also important here since higher rating by issuing firms and analysts will create additional demand for the IPO leading to over subscription.
(Heston, Korajczyk and Sadka, 2009) explain the ration for IPO under pricing through its dealing in secondary markets. In secondary markets since there are no owners involved, investors can strive for achieving the IPO and therefore, pull the prices up. This is one of the main reasons why issuers under price the IPOs. As level of divergence in opinion increase, the level of under pricing also increases. Incorporating divergence of opinion with liquidity considerations also provides insights into the timing of a firms decision to go public and time-series differences in average underpricing. The precise details of the institutional framework potentially have a bearing on the efficiency of the capital-raising process. For instance, regulatory constraints imposed on the bank conducting the deal concerning the pricing or allocation of IPO shares can influence the extent of underpricing, as can the way pricing-relevant information is gathered, aggregated, and paid for.
IPO practices are becoming more and more standardized all over the world (Ljungqvist, 2003). Different frameworks have been adopted by different institutions, allowing sharper tests of theoretical predictions. Lets take an example of United Kingdom where one stop-shop that is familiar with Wall Street competes against financial intermediaries specializing in stock broking or corporate finance they however do not perform both functions. The services that an intermediary provides or offers affect the internal conflicts of interests. The Taiwan Stock Exchange on the other hand discourages book building to the extent that it is not all permitted. A discriminatory price auction system is used in order to find the fair price for the IPO where investors place bids and offers on the upcoming IPO. This might look fair as the price is determined by the demand and supply of IPO and is controlled by the investors interests, but due to the constraints imposed by the market regulator in the Taiwanese market usually result in a severe under pricing of the IPOs. IPOs being one of the major financing methods used by companies all around the world it is very important to conduct adequate IPO research. Ritter (1998) and Ritter (2002) provide useful summaries of the major research findings.
The three stylized facts usually documented in many studies on IPOs include short-term under pricing, hot issues and long-term underperformance. Ritter (1991) discusses about the long-term underperformance of IPOs in the U.S Markets. Ritter and Welch (2002) state that there is a three-year buy and hold market-adjusted and style adjusted (size and market-to-book value) returns of -23.40 and 5.1 respectively for IPO stocks during the period from 1980 to 2001.
Research reports from other sources also identify a similar trend in other countries (Loughran et al., 1995).
Different researchers in Hong Kong report an abnormal negative return of 55 over the period from 1986 to 1996. Morris and Miller (cited in Vong, 2006) spot the declining level of heterogeneity in investors viewpoint. When expectations are high, positive investors start buying the IPO stock in post listing trading activities and drive up stock prices but as greater information becomes available and is processed, the stock price in the market ultimately settles to a fair level at which the IPOs potential is assessed by the market. Ritter (2003) points out those firms take advantage of the windows of opportunity. This can further be supported by Cai and Weis (cited in Parlane and Rousseau, 2007) study on a sample of 180 IPOs listed on the Tokyo Stock Exchange between the years 1971 and 1992. Brav et al. (cited in Parlane and Rousseau, 2007) study a sample of IPO and seasoned equity offering firms from 1976 to 1992 and represent that IPOs of large and medium size generally do not underperform, whereas the small IPOs often display a negative performance in the long term. Yi (cited in Aggarwal, Krigman and Womack, 2002) studies a sample of 705 IPOs from the U.S. market listed between 1987 and 1991 and points out the IPOs that generate a loss at the time they go public generate large negative returns in the long term. Gompers and Lerner (2001) using calendar-time analysis explain that a sample 3,661 IPOs conducted during the period between 1935 and 1972 yield returns competitive to the market. Ritter and Welch (2002) provide a comprehensive and updated review of allocation, IPO activity and pricing.
Oversubscription rate
If an IPO is oversubscribe i.e. its demand is higher than the amount of subscription offered, it positively impacts the level of under pricing. The under pricing level is dependent upon the heterogeneity of information among the investors. Rocks winner curse model (1986) proposes the greater requirement of under pricing with the decrease of information homogeneity. According to the model the heterogeneity of information increases as the demand for the IPO share rises, since the share is rising both informed and uninformed investors will bid on the good IPO (which actually means that the IPO which is performing well in the market) instead of bad IPOs (IPOs that have failed to attract most investors attention) that attract only uninformed investors. Sherman (2004) on the other hand proposed that IPOs that are highly underpriced may attract a higher number of investors looking for greater capital gains. According to Sherman (2004) when the price of the IPO is disclosed before the end of bidding, it is very possible that an information leakage may take place, which can lead to an increased demand for the IPO since its price is already low.
Empirically, many authors have used the oversubscription rate in order to explain the magnitude of the abnormal on the first day of listing. Hanley (1993) imply that there is a positive relationship between the initial performance of a sample and subscription ratio. Similar results are found by Kandel et al. (1999) on the Tel
Aviv Stock Market.
After examining a sample of IPOs by Aggarwal et al. (2008) on the Hong Kong Stock Market, it is determined that there is a positive relationship on the short but the association is negative on a longer horizon. This can be explained by the over reaction of investors in the short run.
Listing time
Listing delay greatly affects the under pricing level of a stock. According to Sherman (2004), the delay in listing creates uncertainty in the market. Since before listing there are no share prices for the IPO in the market so the investors are taking a huge risk since there is high level of illiquidity, such risk should be compensated by discounts on the share price. If a firm takes a time longer than normal to get listed, the expectations for the future of such firm are reevaluated in the market and therefore impact the subsequent level of under pricing. Tse and Yu (2003) find that in Shanghai stock exchange there is a positive relationship between the IPOs listing time and its initial returns. According to the study conducted by Megginson and Tian (2007), a single days delay in the flotation of share in the Chinese market increases the initial return by 0.4. They hold this phenomenon in the Chinese market responsible for the unusually long delays in listing. The lag time however can be attributed to the unintended underpricing which is not usually wanted by the issue. The argument was first initiated by Uddin (cited in Bourdriga et al., 2009) who supports the fact that the exact listing date is not known by the issuers as it does not make much sense for the issue to intentionally owner the lower offer price.
In Tunis stock exchange, the delay that occurs during the time of offer and the time that the stock actually gets listed depends upon the type of offering such as direct registration, minimum price, open price and firm price (Tian and Megginson, 2007). The other factor impacting the duration of listing is the required regulatory clearances and controls. For Tunis Stock Exchange it is obvious that the relation between under pricing and listing of stock is usually unintended. Since there is little or no information available about the time an IPO will actually take to get listed and as the delay gets prolonged, investors lose their interest to trade actively in the market for the specific stock. This will result in the reduction of their irrationality and will most definitely impact the performance of the IPO after it is actually listed.
Offer price
The price at which the IPO is being offered represents the level of underpricing for the particular IPO, although its level seems to have little economic significance (Fernando et al., 1999). The IPO price is usually set at an attractive level in order to encourage the participation of small retail investors. The lower the price higher is the interest of general public in the IPO. Since firms do not set the IPO price randomly they aim to attract the retail investor with a lower price. This in turn leads to a higher demand for the IPO in the market and finally resulting in to a greater under pricing.
The offer price of IPOs is also based on the accuracy of statistics regarding company and its future performance. Higher the level of ambiguity regarding firms future performance, higher will be the offer price set by issuers (Cao and Shi, 2000 Lee, Taylor and Walter, 1999). This rise in price is due to the risk of lower returns expected by issuers when IPOs are floated in secondary markets. According to some researchers, when potential investors have less access to accurate information regarding the company, it is difficult to attract investors towards the IPO and therefore, underwriters or issuers tend to discount the IPO while keeping high offer price so that retail investors are attracted (Kumar, 2007 Heston, Korajczyk and Sadka, 2009 Fama, 1997). Also when institutional parties are involved in marketing of IPOs, they tend to purchase IPOs with high offer prices so that the reputation of issue is strong in eyes of investors. This, therefore, establishes an inverse relationship between IPO under pricing and offer price (Ibbotson et al., 1988). The relationship between IPO under pricing and offer price is derived from the fact that a lower offer price indicates high risks and therefore, to mitigate the speculative trading, issuers tend to go for greater levels of under pricing.
Age of the issuing firm
Age of the firm refers to operational existence of a firm till present. Several researchers have found negative relationship between age of firm and level of under pricing of IPOs (Clark, 2002). This is due to the fact that greater the age of firm, the longer it has existed in market and therefore, has been well analyzed and evaluated by researchers and analysts. This results in availability of information in the market regarding company. As mentioned earlier, uncertainty is compensated by issuers in form of increased under pricing. The availability of historical data results in lack of information asymmetry which is positively related to under pricing. Therefore, the longer the age of firm, the lower the level of under pricing (Ritter, 2003).
Size of the issuing firms
Size of the issuing firm is another important aspect in IPO analysis and pricing. However, this aspect of size is not directly related to risk associated with the IPO of firm. Researchers investigate regarding size of firm to analyze capital that firm already has and potential capital that it can access through its expanded product line. Also firms with large size portfolios are expected to have greater access to resources which can be utilized for growth in future as well as backing for any potential debts or losses. This can also be termed as the asset backing for any firm which is positively related to increased demand for the IPO. According to Kiymaz (2000) and Schultz (1993) potential investors are more inclined towards firms that have larger asset sizes as it provides a cushion against any risks associated with firms operations. Similar observations are made by Vong (2006), Baron (1982) and Clementi (2000) who are proponents of negative relationship between firm size and risk factor associated with the firm. Since a negative relationship between firm size and risk is established through previous literature it can be said that there is a negative relationship between firm size and pricing of IPO as well. This fact is supported by several researchers (Ibbotson et al, cited in Umultu, 2008 Rossolini, 2008 Pons-Sanz, 2005). This relationship is derived from the fact that lower risk associated with a firm will create more demand for the newly listed issue resulting in oversubscription and thus, underwriters will find more incentives for under pricing the IPO. The size of the firm is therefore, an important input in evaluation of subscription rate and under pricing levels.
Size of the issue
Size of the IPO issue refers to total capital amount raised from the equity market through subscription. According to Miller and Reilly (cited in Hill Wilson, 2006) larger issue sizes will be of those firms that have mature business records, larger portfolios and low risk profile. Such organizations when float their IPOs in market, potential investors move the demand curve to the right indicating more subscription or over subscription. Again oversubscription will lead to diffused shareholding under issuers terms and the price of IPO will be kept low for initial gains. Since it is established that normally large size issues are floated by large firms, it can be said that size of the issue is also negatively related to IPO pricing. It also establishes the importance of the factor of issue size in gauging the IPO under pricing practices around the world.
Pricing Methods
Fixed Price Method
Fixed price method is a non-discriminatory method of IPO allocation where underwriters do not collect information from investors (Sherman, 2004 Kumar, 2007). The offer price is set by underwriter without incorporating market demand. Fixed price method involves evaluation of company by financial institution or issuers to determine a price for its initial allocation which is also known as pre-determined price (Sherman, 2004). Fixed price method is a successful and highly popular method among issuers since it provides a greater margin of over subscription and therefore, higher initial returns. The level of over subscription often surpasses normal excess levels and is therefore, more commonly adopted by issuers. This method is often criticized for misguided valuation of firms since in order to oversubscribe, issuers often undervalue the firm to place price below its par value.
The lower price setting is an attractive technique for investors who subscribe to IPO and later earn huge profits on initial days trading.
Book Building method
In order to avoid the issue of under valuation of firms, some issuers adopt the book building method which provides increased benefits for investors and issuers. The book building method involves valuation of firm by insiders who later set a range of prices for investors who can bid on shares (Jovanovic and Szentes, 2007). The range provided by the issuers is based on various elements of comparable companies values as well as firms own valuation. Based on the valuation provided by issuers, the potential investors bid for a specific lot of shares according to their will and estimate of fair value (Gopalaswamy, Chaturvedi and Sriram, 2008). This creates a pool or book of people that create a demand for IPO and therefore, help in determining right price for IPO initial allocation. The issuers then supply the demanded lot of shares in order to achieve equilibrium of supply and demand.
The method of book building presents a fairer value for the firm and is therefore, considered a better way of allocating shares and deciding upon the right price for listing.
The book building method is not only favorable for investors as it presents fair value but also provides benefit for issuers as it provides value for the firm and leads to better pricing method for stable returns after launch. However, unlike fixed pricing method it does not gives abnormal returns on initial trading which is not appreciated by manipulative issuers who want to earn high returns from IPOs (Sahi and Lee, 1999). In comparison to fixed price method book building method is more successful in long run and should be used for growth perspective in mature capital markets.
Hybrid Book Building
Hybrid book building is another form of book building method of offering that is adopted by underwriters and issuers. According to Sherman (2004) hybrid book building will be the most preferred method for under writers and issuers in coming decades since it given added incentives to traditional book building method. In hybrid offerings, book building is used to set the price and to allocate shares to institutional investors a public offer tranche is reserved for local retail investors who do not participate in the price-setting process (Sherman, 2000 2002). In process of book building, initially, the investment bank evaluates the subscription applications and later from a pool of potential investors, selects most appropriate bidders while quoting the price for IPO. Normally, the allocation of shares is more favored towards investors with higher demand (Titman and Sherman, 2001).
One of the main advantages of using Hybrid book building method is the open hand to underwriters regarding rationing of shares and allocation process. Hybrid book building gives underwriters or issuers an incentive to place IPO at their choice of price and to group of trusted investors who under the pressure of maintaining relationships with the underwriters purchase IPO on demanded price. In this way, both underwriters and investors gain from initial returns as the underwriter averages returns over time. However, the retail investors are dealt with differently in order to sell more IPOs. Compared to institutional investors, retail investors are offered the IPOs are reduced price to increase subscription and therefore, increase under pricing and first day returns.
IPO Clustering
IPO clusters are normally formed when information externalities exists in industry and firms take advantage of that low cost of information dissemination to launch IPO and thus create clusters (Cao and Shi, 2000). IPO clustering has been considered a result of industry specific information or investor sentiment. The boom in internet companies and their valuations created a concept of hot markets with issues seeing the unbelievable jumps in their prices on first day of trading. These publicity acts in secondary market by researchers of industry create high demands for IPOs while the underwriters for such firms are keen on under pricing the IPO. Such a gap magnifies the return that can be earned on these issues and therefore, create clusters of IPO under pricing. Hoffmann-Burchardi (cited in Draho, 2004) referred to information externalities, revelation of common value component in process as an important input in price determination process for hot markets.
It is also assumed that IPO price of one firm in an industry is a predictive of prices of other companies in similar industry. Hoffmann-Burchardi (cited in Draho, 2004), in another study considered perspective of an entrepreneur who would go for an IPO launch if the firm has utility-maximizing risk-averse characteristic and if the entrepreneur gains less from the risky cash flow from the firm than selling it to the public risk-neutral investors. The decision of public listing of firms is followed by analyzing its value which is decided based on two main factors. One is the firm specific factor and the other is industry specific factor. Again the entrepreneurs and investors share a different set of information regarding the firm going public. The entrepreneurs will have access to more knowledge regarding the firm as an insider while on the other hand investors will have access to general knowledge about industry and firms that are already listed in equity markets.
This asymmetry of information creates different valuations of firm in eyes of investors and issuers. When issuers assume greater market value for the firm compared to his valuations, they tend to sell shares of issue in the market. Such situation will result in increased under pricing as the demand for issue increases and trading price is greater than valuation by issuers (Burchardi, 1999). Another reason for IPO clustering is depicted by the adverse time selection that is a result of information asymmetry between issuers and investors. When a firm valued high by issuers is undervalued by investors, the secondary market does not offer high returns to the issuers when the issue is sold.
Benninga, Helmantel, and Sarig (2005, cited in Yongyuan, 2008) posit that hot markets are created for issues that belong to firms with highest cash flow compared to industry in which the firm operates. Such value for cash flow grabs attention of investors and industry as a whole and thus, investment inflows are directed towards clustering of the issue. As soon as the positive expectations of market are wide spread and the positive valuations are reduced to an extent, the clustering starts to break up. This end of clustering also takes place due to too much focus on one particular issue which is considered as a hot issue in market and therefore, more than sufficient investment in the IPO leads to decreased demand in the market, thereby, resulting in ending of clustering (Karlis, 1999 Lowry and Schwert, 2002). A research by Lowry and Schwert (2002) investigates relationship between under pricing level and IPO clustering over a long period of time (1960-1997). The study found that there is a strong relationship between IPO clustering and its under pricing. Also the timing of entering IPO markets is also found to be similar for larger issues that enter the markets when other firms are going for greater under pricing levels (Yongyuan, 2008 Gregoriou, 2006).
Apart from the high tech firms that are included in the list of companies with unjustified under pricing levels and valuations, the IPO clustering and its reasons are well researched and explained by researchers in relation to under pricing levels. However, there are still unresolved issues that cannot be explained the most important one being the reason for inclination of industries towards clustering. This issue is important since IPO clustering does not promise long run performance as the clusters begin to end. According to Yongyuan (2008), IPO clustering is merely a method to gather capital for the industry instead of reaction to hot markets.
Initial Returns on IPO
The concept of underpricing of IPOs is directly related to earning of initial returns that a more discounted IPO issue offers. When a company goes public, the underwriter chooses a price, known as offer price, for the initial launch of IPO based on what investors are willing to pay initially (Draho, 2004). The first day trading of the issue starts with the offer price and increase or decrease based on demand of that issue in market. The initial return refers to the percentage difference between offer price and first day closing price of the issue (Draho, 2004). The initial return greatly depends on the level of underpricing that company has done and the basis on which underpricing is done. However, most researchers suggest a positive underpricing, that is underpricing according to the positive value that firm is believed to offer in future, since the initial overvaluation leads to bad aftermarket performances of IPOs (Gregoriou, 2006).
A study by Barry and Jenny (1993) obtained initial day opening and closing prices for 229 recent IPOs in U.S. In their study, Barry and Jenny found that the IPOs listed and operated on first day gained substantial returns. This isolated the intraday timing of the first days return. The study also revealed that 90 of the return earned on initial days is earned during opening transaction and early hours while the remaining transactions depict average results of transactions costs. This result is consistent with the notion that general market participants on first day trading of IPO gain less from buying and selling of IPO compared to investors who had originally invested in issue before launch in market. This, therefore, indicates that initial returns for IPOs are greater and significant for IPO participants instead of general investors in equity markets.
Another study by Chung, Li and Yu (2005) predicted that initial return is positively related to both the size and risk of growth opportunities. Along with this initial return is also found to be positively related to fraction of the offer price and uncertainty associated with the issue itself. The fraction of offer price is accounted for the present value of firms future strategies and potential. The study also derived the fact that normally one dollar of future incentive in firm is equal to three quarters of tangible assets (Chung, Li and Yu, 2005).
Before consideration of initial returns it is important to consider the issue of valuation that creates a gap between actual market price and IPO subscription rate. There is an obvious different between pre-IPO market risk and risk associated with regular trading in equity markets. Since complete information regarding a company is available after its listing on stock exchange, it is different than pre-listing risk as the investors and issuers have dubious valuation methods. Without consideration of market consensus, the IPO market participants evaluate the offer price or subscription rate according to their own models, some of which have been discussed below.
Valuation
Valuation is an important aspect of under pricing of IPOs which is related to both intraday returns as well as asset-backing ratio of a firm. An immediate question raised by the difference between the offer price and the first-day market price is whether issuers or the stock market is pricing offerings in line with a firms fundamentals. The valuation firms generally evaluate firms value on basis of its competitors or firms with equal statistics (Campbell, Du, Tang and Rhee, 2008). However, this solely cannot be used to evaluate a firms market price since accounting data is not completely reliable and relevant since investors need to know the growth factors associated with listing firms instead of their past performances. This asserts that the tests for checking accuracy of firms valuation and market price are weak to represent true value of a firm. Therefore, in order to do proper valuation large samples are required to authenticate the price results from valuating firms. Several researchers have worked on explanation of using accounting information efficiently to achieve true and fair value of a firm.
A research presented by Kim and Ritter (cited in Welch, 1992) applied earnings forecast along with accounting multiples to calculate firms value, however, the research still presents only a reserved form of accuracy. Similarly, Purnanandam and Swaminathan (cited in Vong, 2006) presented notion of using intrinsic value which was based on ratios of price to revenue and price to EBITDA formed on basis of industry comparison. The researchers used a large sample of 2000 IPOs using both fixed price and book building methods. The results depicted that when offer price method is used the ratio of under pricing rises up to 50. The study also related this level of under and over pricing with long run underperformance through calculations of initial returns with respect to subscription costs.
Subscription costs
It is very important to understand the relationship between IPO returns and the cost of subscription. Cost of subscription is an important factor in determining the initial return for the IPO. Subscription cost of an IPO usually includes the financial costs and per share transaction cost.
In order to arrive at the total cost involved in receiving the IPO and selling them on the first trading day, Fung, Cheng and Chan (2003) presented a paper on cost of subscription and its relationship with IPO under pricing. The researchers started with assuming that the subscriber borrows or withdraws the money from the bank at Offer Price (1Per dollar up front exchange fee and handling charges) on the last day from subscription for a single share. After replacing offer price with Op and per dollar up front exchange fee and handling as H1 the equation becomes,
OP (1H1).
Assuming that the investor sends the application at the last moment on the last allowed day for IPO subscription the interest accrual starts at t0. In case the IPO is undersubscribed the investor will receive one share before the day that the IPO is first listed. We will call this day t2. If the investor sells his one share on the first day of listing, the investor will receive the proceedings from his sale of share on the settlement date. The settlement date can be T1, 2 or 3 but most Asian exchanges have the settlement of T2 for normal settlement. It also important to note what day is falling on the first day of trading. If the is Monday to Wednesday the seller will receive the money two days later. In case the day listing day falls on Thursday or Friday then since the markets are closed on Saturday the trades on Thursday will be settled on Monday, where as the trades on Friday will be settled on Tuesday. If the listing day is on Thursday or Friday, however, money will be available four days later on the Monday or Tuesday. In case the subscriber has borrowed money from the Bank his interest will accrue for 2 days if the subscription day was Monday to Wednesday and for Thursday and Friday the interest will accrue for 3 days. The borrowers balance will be adjusted as soon the check from proceeds is deposited with the bank as interest is charged only on the balance due overnight.
In case the IPO is oversubscribed and if the investor receives only a fraction (f) of a share of the IPO, then the investor will receive a check for the remaining amount the next day, whereas the amount for which the investor has received shares will be liable for accrual by the bank. For the amount which will be returned will only charged with the interest for one day, or we can say t1. The investor will receive an amount net of the shares received, for a single share subscriber receiving the fraction (f) can be written as
(1 - f) OP (1 h1)
which will be used to offset the (debit) balance or redeposit the money in the bank.
So all in cost of funds per for a successful IPO application can be calculated by,
Equation 1
With compounding interest
Where
Ct2 k all-in-cost of funds per share of a successful subscription on the settlement
Day for the listing-day sales proceeds
t2 listing or first trading day
k settlement delay due to the settlement conventions
k 1 if t2 is Monday, Tuesday, or
Wednesday
and k 3 if t2 is Thursday or Friday
f overall percentage of successful applications
Op offer price of the issue
q1 total exchange and handling charges levied on the new issue
t1 refund day, when excess funds and money from unsuccessful bids are refunded
t0 deadline for application
ri and rj interest rates
From the equation above, we can calculate the all-in-cost of funds per share successfully subscribed. It is related positively to the interest rate level i.e. higher the interest rate, higher will be the total cost of funds , transaction costs, number of days between the last day of subscription and the day of refund , number of days between the listing day and the day of settlement of sold security, and the rate of subscription. For example, if the subscription rate (1f) is 100 times, the offering price (Op) is HK20, the total exchange and handling charges on the new issue are (q1) is 0.1, the interest rates (both ri, and rj) are at 10 , and there are ten days for each of two periods (t1 - 1 - t0 and t2 k - t1), the total IPO subscription cost is HK25.16, which is 28.4 higher than the subscription price.
Warrants
Warrants are often attached with IPO issues in the Asian equity markets like Hong Kong (Tse and Yu, 2003). The warrants are usually issued to attract more IPO subscribers to the issue and they are like bonuses. The equity and warrant combined is usually called a unit or unit IPO.
The total revenue from selling shares and attached warrant on the first day of listing can be represented by,
Equation 2
Where
TR t2k total revenue from selling the share and warrant if any on the first day of listing.
Pt2 Price of stock on the first day of listing
w Total number of warrants attached
Wt2 Price of warrant on first day of listing
q2 trading cost for selling the stock and the warrants.
By combining Equations (1) and (2), we get the totals return (r)
R is derived by adjusting all the cost of fund, settlement date on the basis of settlement terms and the day on which the listing is taking place, the movement of stock before the listing day and price on the listing day and the effect of warrants if attached.
Equation 3
r is the market adjusted IPO return, I stand for the stock market index.
Equation yields the market-adjusted actual IPO returns incorporating total subscription cost. If interest rates are at 0, the return in Equation (3) would converge to the conventional IPO return measure.
In order to represent the differences between conventional IPO returns and IPO returns after adjustment of Subscription costs, Yongyuan (2008) examined a sample of around 136 IPOs in Hong Kong between year 1993 and 1995. The data set contained issuer characteristics such as offer size of the IPO, offer price, deadline of subscription, date when distribution is determined, listing date, and the date of refund. Yongyuan used local deposit rate as an alternative for the opportunity cost of funds for investors utilizing surplus cash reserves for the payment of IPO and for the borrower, prime lending rate was used as an alternative for the financial cost. The total trading cost, comprised of a brokerage commission cost as a division of the total transaction value, stamp duty, transaction levy imposed by the stock exchange, transfer deed stamp cost, and transfer fee per share being transferred. Therefore, the total cost for selling the share was calculated for the sale transaction value.
The Hong Kong IPO Market
Market Overview
The capital market of Hong Kong has gained increased attention during 2000s and especially 2005 with equivalent boom in newly listed companies. During 2005-2007, the total capital raised by board of Hong Kong Stock Exchange is equivalent to HK788 billion which is far above the capital raised during 1980s and 2004. The practice of fixed price offering is mainly implemented that often result in heavy over subscription for IPOs and therefore, generate hefty profits for issuers and investors. With this rate the over subscription level in Hong Kong is recorded to be about 190 times and have concentrated about HK40 trillion in the receiving banks.
A paper presented by Cheng, Cheung and Po (2004) examines theintradaypatterns of IPOs in Hong Kong during the period 1995-1998. The results reveal that the well-known under-pricing phenomenon of IPOs occurs only at the opening trading of new issues and vanishes afterwards. Thereturnvolatility of IPOs is found to be high during the first trading session, and declines rapidly during the rest of the first trading day until the end of the trading day. Theintradayreturnvolatility of IPOs is found to follow a double U-shape pattern, which is similar to that of the general market. A great deal of trading activity was recorded during the first five minutes of the trading day. Consistent results are obtained for IPOs registered during the pre-crisis and post-crisis periods. This paper has practical implications for investors. Investors can benefit from the under-pricing only if they subscribe for new shares in the primary market. There is, however, no profit-making opportunity for day traders who buy shares on the first trading day. This shows that the Hong Kong market is efficient in adjusting for the IPO under-pricing. In addition, it is likely that, because of Hong Kongs share allotment method, only big investors who apply for large numbers of shares can benefit from this under-pricing phenomenon.
The activities in Hong Kong equity market have favored the countrys economy as these results in larger capital inflows. Based on the statistics, 2005 and onwards period in Hong Kong has seen a boom in economy and an equivalent boom in IPO listing. The capital inflows and outflows have increased by substantial level and have exceeded 100 of Hong Kongs nominal GDP as recorded in 2007. The increase in demand for transfer of private firms to public firms has resulted in growth of loan credit department nationwide as interested investors are looking for supply of funding. This increases the domestic demand for loan thereby, increasing loan growth. Leung and Ng (2008) showed surge in loans growth by 991 during March 2007, 1259 in June 2007 and by 258 in September 2007 i.e. loan growth results at the end of each quarter.
The banking industry of Hong Kong is largely affected by the IPO market due to impact of IPOs on interest rates or more specifically inter-bank rates (DSouza and Gaa, 2004). Since the investors demand funding from banks, the supply of funding in market reduces compared to demand of funding. This put an upward pressure on interest rates and pulls the rates up. Similarly, the transfer of funds by bidders to receiving banks, both lead and sub banks, requires borrowing by sub banks in order to pay to lead receiving banks and in turn, the lead receiving banks have to pay to issuers the amount paid by IPO participants. This creates demand for inter bank borrowing which again pulls interbank rates up.
According to Yongyuan (2008) and Leung and Ng (2008), the Hong Kong market has seen strong affect of IPOs on interbank rates that increased interest rate volatility and caused inversion of the interbank yield curve at the short end. Similarly, the foreign exchange operations of Hong Kong exchange markets also require analysis of IPOs and their under pricing levels as well as analysis of factors like subscription rates to evaluate impact on interest rates.
Several researchers have conducted research on Hong Kong IPO market that is configured in a single-tranche offer form (McGuinness, 1992 Cheng et al., 2004 Fung et al., 2004 Vong, 2006). However, the recent IPOs in the market utilize dual-tranche offer form which is investigated by McGuinness (2009). In a dual-tranche offer, the retail offer is made along with a book built placing. Using such method adjusts the problems of demand and supply funding in market. This feature was not available with single-tranche offer thereby, introducing different pricing method previous practices. There are several factors that can explain under pricing and clustering of IPO issues in Hong Kong market, most significant being the subscription rates by retail prior to a given offering as well as performance of secondary markets. One of the main bodies that act as regulatory bodies regarding IPO issues is the Mainland PRC-incorporation who is the H-share issuers in Hong Kong. According to Vong (2006), the IPO subscription rates and after market volatility is directly related to initial returns in Hong Kong.
IPO Listing Procedure
The listing of securities on the HKEx main board is regulated by the Rules Governing the Listing of Securities on the HKEx. Like other capital markets, there are several regulations for listing equity securities on Hong Kong Stock Exchange. The list of requirements for securities is given below.
Firstly, the companies that wishes to be listed on HKEx need to present their financial as well as other firm related record of minimum three years period so that investors can have background data on the firm. Secondly, the minimum profit for shareholders up to the date of application for listing should not be less than HK50 million for past three years with recent years profit of minimum HK20 million. The requirement for market capitalization is minimum HK 100 million for each firm and lastly, among the various classes of listed securities, public must have access to holding of at least 25 shares. This percentage varies according to market value of the firm to be listed.
The listing method approved by Hong Kong Stock Exchange is the method of offer for subscription which involves an issuer who sets initial price for the IPO and through share allocation method investors get hold of IPO shares.
Subscription
As with any other capital market, underwriters are hired by issuing companies or financial institutions are required to act as issuers for the IPO. It is the duty of underwriter to distribute listing firms prospectus among potential investors to provide an insight into firms operations, its financial conditions and market value. This information is disseminated through various sources including electronic media, newspapers, financial institutions and other marketing sources. An application period is allocated for investors to bid on IPOs. The application is submitted along with bank draft to underwriter who further proceeds with the process of subscription and allocation. Under conditions of oversubscription, underwriters have an added responsibility of allocating shares to subscribers fairly which is later on inspected by the HKEx. Generally, the allocation process is done in four to five days with a special consideration in case of over subscription. The list of subscribers is then given in newspapers and trading documents under share allotment section.
Closing periods
When potential investors or bidders plan to invest in a specific IPO, they submit applications along with application dues and IPO price to branches of receiving banks. To limit the number of applications, a closing period is decided and announced by the under writer until which the investors can submit their applications. The receiving bank gets commission from the issuing company to collect the applications for IPO issue. In order to submit applications for the IPO, investors need capital which is either provided privately or through a loan from sponsor bank. Such transactions require heavy flow of capital from investors or sponsor banks to receiving banks which can limit the ability of sponsor bank to provide funding. For this purpose, there is borrowing between sponsor bank and receiving bank. The transfer of funds related to IPO applications often move the interbank market in general as increased demand for fund borrowing can result in increase in interest rates, thereby affecting the inter-bank markets (Leung and Ng, 2008). The total process of IPO issuance, closing dates and refunding process is indicated in figure 4 in appendix.
Share Allotment
The procedure of share allotment in Hong Kong is similar to that of most of European markets with random allocation of shares process by underwriters and issuers. Normally, the fixed offering price is used and rationing of the shares is generally resulted because of oversubscription and undervaluation of firms.
Cheng, Chan and Mak (2005) in their paper introduce two measures of allotment ratios for small investors to examine the strategic share allocation strategy of IPO underwriters in Hong Kong. The study indicates that underwriters use non-discretionary allocation of IPOs to favor small investors in Hong Kong. This supports the phenomenon that in markets like Hong Kong with less trust worthy investment institutions and efficient market practices, allocation of shares to smaller groups is a general practice by issuers or under writers. This prevents from formation of larger lots of investors who can threaten the ownership control of firms to be listed. These results also mark difference between capital markets of United States and Hong Kong where larger lots of IPO shares are allotted to big investors with trust worthy intermediation of financial institutions.
Refunding period
The refunding process involves transfer of application dues to a receiving bank which will be the lead receiving bank. Among the receiving banks, there are two types of banks lead receiving bank and sub receiving bank. During this refund period, the sub receiving bank gets application dues from lead receiving bank and transfers it to issuers account (Leung and Ng, 2008 Williams, Duncan and Ginetr, 2006). A system of Real Time Gross Settlement System (RTGS) is used by the banks to adjust payments to issuer from lead bank (HKEx, 2009). These payments remain with the issuers until allocation process is done and list of successful bidders is released. After the list of successful bidders is released, the unsuccessful bidders payments are again transferred from lead receiving banks to the bidders. For this purpose, as opposed to closing period, payments are sent through cheques and e-IPO payments by lead bank to investors. The application dues also vary from issue to issue with the oversubscribed issue being the most costly one and can put lead receiving bank under pressure for fund allocation which can be then borrowed from sponsor banks.
Conclusion
The existing literature on IPOs underpricing presents a broad array of aspects that provides investors an in depth view of IPO markets and factors associated with it. One of the main conclusions that can be drawn from the existing literature is that IPO underpricing is a norm all over the world and underwriters under price the IPOs for several reasons and gains. There is irregular flow of information regarding companies and their characteristics that result in under or over subscription which in turn results in unusual gains or stagnant returns in after IPO market. Also firms have several motives behind the underpricing, ranging from litigation evasion to wealth gains for investors. Among the range of hypothesis and dimensions of IPOs, this study will focus on the Asymmetric Information Models where among the various categories company characteristics and offering characteristics will be studied to gain insight into the relationship between IPOs underpricing and rate of subscription and asset-backing ratios. The methodology used by Vong (2006) and McGuinness (1992) will be followed with main focus on regression analysis, however, on a new sample of data from Hong Kong Stock Exchange.
Methodology
Nature of Study
Based on the nature of research topic, the study will be a statistical analysis of variables to prove hypothesis. The statistical method is an effective way to answer the research questions by examining whether a relationship exists between two or more variables (Vong, 2006 Loughran Ritter, 2004 McGuinness, 1992). Using the quantitative correlational design is consistent with previous research that studied the relationship of independent variables and the underpricing of IPOs (Vong, 2006 Loughran Ritter, 2004 McGuinness, 1992). This study uses a quantitative co-relational approach. In co-relational approach covariance and correlation between two variables is determined to establish the directions, magnitude and forms of observed relationships (Bordens, 2006). This approach belongs to non-experimental research where only observations are made. Unlike experimental research where researcher has high control over the variables of study, non-experimental quantitative approach will collect data of interest and analyze the relationship between variables based on the data.
Hypotheses Testing and Types of Statistical Analysis
The research will include generalization process by selecting a sample of data to generalize it to the population. Several hypotheses will be established to conduct the research. Hypothesis testing refers to method of presenting a proposed explanation for an observable phenomenon. The first hypothesis asserts that the assets-backing ratio is positively associated with the level of the intraday return. If the initial return is positively regressed against the independent variable of the assets-backing ratio, the relationship between them is significant. The question What is the degree of relationship between the assets-backing ratio and the intraday return of the IPO is then transformed into the following null hypothesis and alternate hypothesis
H10 There is no significant relationship between the assets-backing ratio and the intraday return of the IPO.
H1a There is a significant relationship between the assets-backing ratio and the intraday return of the IPO.
The hypotheses presented above can be supported through statistical proofs for the relationship between asset backing ratios for firms and their intraday returns. Data will be collected from the accounting reports of firms with IPO issues and their asset position will be assessed for a specific time period. Similarly, the intraday return will be collected for IPOs and the variables will be compared to establish positive or negative relationship between asset-backing ratio and intraday returns for the IPO and therefore, prove null or alternate hypothesis.
The second questionWhat is the degree of relationship between the rate of subscription and the intraday return of the IPO assumes that the rate of subscription is positively associated with the level of the intraday return. If the initial return is positively regressed against the independent variable of the rate of subscription, the relationship between them is significant. The second question is then used to develop the following null and alternate hypotheses
H20 There is no significant relationship between the rate of subscription and the intraday return of the IPO.
H2a There is a significant relationship between the rate of subscription and the intraday return of the IPO.
The hypotheses presented above can be supported through statistical proofs for the relationship between rate of subscription and intraday returns. The observations and data will be collected for IPOs on HK Stock Exchange and their return will be observed for a specific period. The positive or negative relationship that will be determined between both factors will support either null or alternate hypothesis.
ConstructsVariables
The intraday return, the assets-backing ratio, and the subscription rate are the key variables used in this studys regression analysis. The dependent variable is the intraday return, which is calculated as follows
Intraday return (share price of a stock at the close of the first day of tradingshare price of a stock at the time of offering) (The Hang Seng Index at the close of the first day of trading for a stockthe Hang Seng Index at the time when the stock was offered).
The intraday return is directly proportional to the underpricing of a stock that is, a higher intraday return indicates a greater degree of underpricing for a new offering (Vong, 2006). The choice of the first aftermarket daily return is consistent with the findings of McGuinness (1992). His study empirically validated the assumption that mean daily returns, except for those of the first day, are not significantly different from zero. The higher the initial return, the more underpriced a new offering is assumed to be. The first independent variable is the assets-backing ratio, which is equal to the adjusted net tangible assets per share divided by the offer price.
Other factors that may influence the association between these independent variables and the dependent variable need to be controlled. The controlled variables refer to variables that are not changed during the whole study due their insignificance and minor impact for researcher. Such control variables might have minor affect on other important variables of study and thus, are required to be kept constant. The control variables of underwriter reputation and auditor reputation are used in this study. The underwriter reputation and auditor reputation are least important factors for this study since their impact on IPO underpricing is although significant yet, does not need explanation in this study and in relation to subscription rate and asset backing ratios of firms.
The study will focus on elementsvariables that are expected to reflect upon characteristics of IPOs and therefore, have strong relationship with subscription rate and intraday return. There are several variables that can be considered in this study including offer time i.e. timing at which the issuers are planning to float IPO in market. This will include market conditions or state and its characteristics. Table 2 given in appendix displays all variables that were used by Vong (2006) in his study related to IPO and its associated factors. These variables are valid for this research as well since this study intends to study factors that affect rate of subscription and under pricing levels of IPOs in Hong Kong.
In order to investigate the intraday return patterns, it is also important to study over all initial returns. The return of an IPO cannot be measured without inclusion of returns from previous IPOs in Hong Kong market as assumed by various researchers (McGuinness, 1992 McDonald and Fisher, cited in Vong, 2006 Alli et al., 1994). Therefore, intraday returns for past six years have been collected i.e. from 2003 to 2008. The data has been collected for firms that went public during this period and thus, help in establishing relationship between firms characteristics and under pricing level which further relates to intraday return.
Validity is a measure which is used to determine the extent to which a given tool actually evaluates what it is meant to evaluate. Stated differently, validity determines the legitimacy of the obtained results. Validity demonstrates the extent to which the collected data reflects the reality. For the outcomes of any research to be considered useful, it is essential that they be deemed as valid. There are two major aspects of research design that are needed to be considered before carrying out the research internal and external validity of research design (Thomas, Nelson Silverman, 2005). The ability of a research design to properly test the hypotheses is known as internal validity while external validity refers to the degree the study results can be extended beyond limited research settings or sample (Bordens, 2006).
Reliability is used to exemplify the extent to which the results obtained are consistent. Reliability is also a measure of how free studies are from error. In order for studies to be deemed reliable, the result obtained ought necessarily to be consistent, accurate and should be able to be replicated.
To ensure that the results of this study are both valid and reliable, the following steps will be taken. First, advanced search techniques will be used in order to be enabled to include as many studies as possible. This will help to limit and possibly prevent inaccuracies occasioned by selection bias. In order to limit inaccuracies occasioned by erroneous studies, suitable inclusion criteria will be employed. Thus, only high quality studies will be appraised and flawed sources excluded accordingly.
Data Collection and Analysis
The data contained in this paper has been retrieved from several sources however, the website for the HKEx is the most important of these sources. The list of IPOs for each year and their prospectuses can be found on the HKExs website. The remaining data was collected from financial information found on finance.yahoo.com. To obtain a representative sample, the researcher selected IPOs occurring from 2003 to 2008. Specifically, the sample for this study consisted of 284 IPOs that appeared on the main board of the HKEx from 2003 to 2008. The sample period from 2003 to 2008 was chosen due to the lack of research investigating the underpricing of IPOs during this period. The number of observations and the period of analysis should be representative of the most recent IPO market conditions, especially during the recent financial crisis that started in late 2008.
Analysis
The study for determining the nature of correlation between the variables is done through regression analysis. Regression analysis is the statistical tool that is used identifies the relationship between two or more variables (Sen Srivastava, 1990). The regression analysis is normally used to determine the causal effect of one variable over another. The steps involved in regression analysis will consist of inclusion of important variables, sample determination, data collection, and calculation of coefficients and their relationship and finally overall analysis and conclusion regarding the relationship between variables.
The type of analysis involve in this research is Multivariate Data Analysis. Multivariate data analysis is another statistical tool that analyzes data derived from more than one variable (Esbensen, Guyot, Westad and Houmoller, 2002). This essentially models reality where each situation, product, or decision involves more than a single variable. For this research masses of data in each field are available and therefore, multivariate data analysis is used to filter out the most useful variables and do analysis according to requirements.
Multivariate analysis methods are normally used in researches related to following factors
Quality assurance analysis in companies related to field of food, beverage, paint, pharmaceuticals, chemicals, energy and many more sectors.
Consumer marketing projects
Research and development
Process optimization and process control
Principal Component Analysis
Principle Component Analysis is an important tool under Multivariate data analysis where summary of tables is used o identify important and obvious patterns. The process further analyzes groups in those tables and then establishes relationship between columns in tables. The objective is to use one set of variables (columns) to predict another, for the purpose of optimization, and to find out which columns are important in the relationship (Esbensen, Guyot, Westad and Houmoller, 2002). The corresponding analysis is calledMultiple Regression Analysisor Partial Least Squares(PLS), depending on the size of the data table
The mean and standard deviation of each variable will be given by the researcher for the study. Pearson correlation will be used to explore each relationship between the variables. Correlation is an effective way to examine whether a relationship exists between two or more variables (Vong, 2006). The correlation coefficient will also be used to provide a measure of how strongly the variables might be related. If the correlation coefficient is large, this will indicate that there is a strong, positive, linear relationship between two variables.
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